News & analysis

With cross-asset risk sentiment weak due to the degree of ongoing political risk and last week’s strong US payrolls report still fresh in the mind for most traders, the bar for US core disinflation to trigger a substantial sell-off in the dollar was elevated heading into today’s May CPI report.

Given structural lags in components like shelter and strong momentum in core services, we thought the odds of this occurring were slim. Consensus expectations shared this view, with the average core inflation forecast predicting only an incremental improvement in the pace of core inflation from 0.29% to 0.28% MoM. Printing at 0.163%, however, the data defied the odds and reflated Fed easing bets, weighing on the broad dollar and providing a curveball for the FOMC who are set to announce their policy decision alongside updated economic projections later today. Heading into today’s CPI report, we suspected policymakers would revise down their median projection for rate cuts this year from 3 to 2, with risks skewing in the direction of less easing both this year and next.

While we continue to expect the median dot to reflect one less rate cut this year, risks surrounding the Fed’s median projections are likely to be more balanced than we initially believed. This will reflect the sudden stop in US core inflation momentum, balanced against the fact that the substantial progress back to target is visible in only one report.

As mentioned, the key variable for markets today was how core inflation printed on an unrounded basis. At 0.163%, the pace of price growth cooled considerably in May, dropping from 0.292% in April and an average pace of 0.37% in the first quarter. This led to sustained disinflation in the annual rate, which has now fallen 0.4pp from 3.8% in March to 3.4% in May. Moreover, the shift in underlying momentum suggests further disinflation is in store as the 3-month annualised pace of core inflation has now cooled by 1.2pp over the same timeframe to sit slightly below the year-on-year rate at 3.3%.

The good news for markets and Fed policymakers doesn’t end there. Behind the slowdown in core inflation pressures were core services ex-shelter components, also known as the supercore measure of inflation.

This sub-index of inflation fell dramatically from 0.42% to -0.04% MoM, primarily due to a sharp contraction in airline fares (-3.6%), video and audio services (-1.3%,  and motor vehicle insurance (-0.1%). On a 3-month annualised basis, preferred amongst policymakers as it smooths out monthly volatility, supercore inflation fell more than 2 percentage points in a month from 6.35% to 4.19%. More specifically, it now sits at close to half the 8.18% level achieved back in March that previously fuelled market concerns over inflation persistence and the growing risk of no Fed rate cuts this year.

After pressures intensified in the early 2024, underlying inflation is now easing sharply. Renewed disinflation momentum is now set to weigh further on the annual rate of core inflation

Inflation outside of components covered by the supercore measure evolved largely as expected. Core goods continued to provide a deflationary drag, albeit to a lesser degree at just -0.04% MoM. This was as apparel prices fell -0.34% on the month, alongside a -0.49% reduction in new vehicle prices, though this was partially offset by used cars and trucks, where prices rose 0.6% in May. Moreover, structural lags remained present in shelter components, where prices rose 0.4% MoM, down slightly from the previous 3-month average increase of 0.41%. Specifically within shelter, owners’ equivalent rent of residence accelerated moderately from 0.42% to 0.43%, while rent of primary residence inflation sped up more notably from 0.35% to 0.39% MoM.

In and of itself, this won’t be a concern for policymakers as the path of shelter disinflation is widely expected to be bumpy, but sustained given the strong signal provided by leading indicators.

If last month’s inflation report was graded a C+ by Waller, we suspect today’s would be given an A-. While core inflation now annualises just below the Fed’s target at 1.97%, policymakers and market participants alike need to see the same rate of progress replicated over a few more editions before full marks can be awarded, especially given persistent tightness in the labour market. We now expect Chair Powell to relay a similar message at today’s press conference, with questions likely to centre on whether the Fed can cut rates based on inflation progress alone or whether policymakers also need to see more slack emerging within the labour market.

Given both economic indicators have provided divergent signals, Powell’s answer will likely determine the extent to which easing expectations can reflate and the next leg for the dollar, which after today’s data is essentially back at levels seen prior to last week’s payrolls report.

Expectations of a Fed cut in September have retraced back to pre-payrolls levels alongside the broad dollar index 


Simon Harvey, Head of FX Analysis

Nick Rees, FX Market Analyst


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